Fiscal Cliff: Reality Show or Morality Play?

The gruesome package of spending cuts and tax increases scheduled for December 31 was dubbed the "Fiscal Cliff’ by Federal Reserve Chairman Ben Bernanke. It’s apparent why the phrase caught on. Less understandable is the urge to jump into equally dangerous policy options.

Virtually all of Washington is unhappy with the prospect of the measures. For months there’ve been reports of informal meetings to create a fix. But the austerity-worshipping ethos that underlies the plan is firmly entrenched, and some version of it will be enacted. Because of the wounds that extreme austerity will inflict, the Levy Institute is predicting—and we’re hardly alone—that we’re headed for another recession in 2013.

All the evidence confirms that austerity programs have been a counterproductive disaster in Europe. That hasn’t persuaded fiscal conservatives to adapt their ideology to reality. They continue to point to the inevitability of a Greek or Portuguese-style meltdown in the United States unless we immediately put government on a no-calorie diet and extract higher tax payments from those least able to afford them. This is despite the understanding by economists, including the most orthodox, that our federal control of the dollar puts us in a fundamentally different position than that of countries yoked to the euro.

What we should be watching instead is the sorry mess in the United Kingdom. It’s a more relevant comparison because, like the United States, the UK controls its own money; it stuck with the pound and never adopted the euro.

Britain’s own fiscal cliff was the 2010 austerity agenda of Prime Minister David Cameron and the Conservative Party. A set of drastic measures aimed to increase growth and reduce debt, it has failed spectacularly on both fronts. The UK economy today is indisputably worse than it was when the tightening began, with a shrunken GDP and the deficit shooting up. Government spending cutbacks—integral to the plan—helped bring about this new recession. Cameron and Chancellor of the Exchequer David Osborne have yet to take responsibility for their policies, accusations of incompetence from the press and a slap-down from the International Monetary Fund not withstanding.

The U.S. Congress seems determined to follow this running leap into extreme austerity. The most likely modification to the current plan is an extension of some of the Bush-era tax cuts. Yet there hasn’t been any move to extend the payroll tax holiday. Workers on the low end of the pay scale need the additional take-home pay that this measure has been providing. Because these employees spend their paychecks (they save the least of any group), they’ve also been helping to stimulate the larger economy. To eliminate this prime tax relief issue for the working class would be a major blunder.

Slashing federal agencies—the planned "sequestration" of Treasury Department funds when the overall budget hits a targeted figure—would be even worse. Medicare and Medicaid are exempt, but if the pressure to restore military spending succeeds, countless key economic drivers will have to be decimated instead, in order to reach the magic targeted number. With the pain spread across a wide range of departments, you might assume that the impact would be insignificant. No. The shrinkage would be, roughly, a substantial 12 to 15 percent. The cuts would lead to another recession here, in a mirror of what’s happening in Great Britain.

The trap that occurs when austerity measures are used to balance a budget is predictable and preventable. On the most simple level, spending cuts and tax increases promote a cycle of low demand (because consumers buy less), low profits, high unemployment, and slow growth. These, in turn, inevitably lead to lower tax revenues and higher government safety net payouts, which of course produce rising government deficits. Greg Hannsgen and I detail other factors that also play significant roles in a new report [Fiscal Traps and Macro Policy after the Eurozone Crisis]. The austerity cult’s response to this cycle is bigger spending cuts and more tax increases, which lead to … you get the idea.

What’s at the heart of this irrational strategy? A mistaken belief that our national economic problems stem only from a failure to control spending. The data shows that this simply is not the case. Total United States government spending has actually been falling as a percentage of GDP, while the total number of government employees has been declining. This alone clearly indicates that our deficits—like those in the UK, by the way—have more to do with meager tax revenue than with profligate spending.

Also key to the craze is the belief that austerity measures cannot wait. Many in Washington and the media are convinced that the recovery is well underway, and if spending cuts and tax increases are delayed for even a year it will be too late to tame inflation and tighten fiscal policy on a soaring economy. The urgency rests on unfounded optimism. We still have a very long way to go before the economy is anywhere near healthy enough to heat up. The GDP is now, and has long been, far below trend.

Our economic malaise has been consistently underestimated, and the result has been the adoption of inadequate half-measures. Swapping budget cuts at the edge of the fiscal cliff isn’t a solution. A reduction in federal spending during a downturn will perpetuate the damaging cycle, no matter how judiciously the cuts are chosen.

The sequester should be repealed outright, and it certainly should not be replaced. We need a strong stimulus that increases employment, not by wishing for it, but through public sector hiring. The Fiscal Cliff show is a morality play that celebrates puritanical righteousness and unnecessary punishment. As we’ve already seen on the UK stage, it’s headed towards an unhappy ending.